Three Rules Retails

Shopping for successThe three rules in retail

Rodney SidesRod Sides serves as the leader of Deloitte Consulting LLP’s Retail and Distribution practice. He has more than 25 years of experience assisting leading retailers and distributors in improving the efficiency of their operations and in increasing overall profitability. His experience spans the entire enterprise, including store operations, supply chain, procurement, back-office operations, and infor-mation technology. He specializes in SG&A cost optimization, helping his clients drive sustainable change across the organization.

Vikram RaoVikram Rao is a senior manager in the Audit & Enterprise Risk Services practice at Deloitte LLP. He has over 10 years of experience in providing technology risk services to large global Fortune 100 clients in the retail and consumer products industry. Within technology risk, Rao specializes in providing cyber risk services, which help clients to be secure, vigilant, and resilient in the face of an ever-increasing array of cyber threats and vulnerabilities. He also has deep experience in internal audit and risk and controls assessment services. Rao has a bachelor’s degree in computer engineer-ing and a master’s degree in systems science, and holds the following certifications: CIA, CISA, CISSP, CRMA, and PMP.

Tonya A. WilbornTonya Wilborn is a senior manager in the Audit & Enterprise Risk Services practice at Deloitte LLP, specializing in the area of business process controls assessment and internal audit. She has over 14 years of experience, focusing on Sarbanes-Oxley readiness, internal audit outsourcing, and project management for IT and ERP implementations. Wilborn is a graduate of the University of Texas at Austin, with a bachelor’s degree in business administration with an emphasis in accounting. She is a Certified Internal Auditor (CIA) and holds a Certified Risk Management Assurance (CRMA) certification.

Whitney J. YoungWhitney Young is a senior sector specialist within Deloitte LLP. Her retail work spans merchan-dising, pricing, store operations, and digital strategy. She advises Deloitte’s national retail sector leadership on key strategic, operational, and eminence-related activities to support and grow the cross-functional practice that provides audit, tax, financial advisory, and consulting services to retail, wholesale, and distribution companies.

About the authors

AcknowledgementsThe authors would like to offer special thanks to Robert Del Vicario, Robert Libbey, Subramanian Neelakantan, Derek Pankratz, and Sadashiva S. R. of Deloitte Services LLP for their contribu-tions to the research. They would also like to acknowledge the contributions of Jean-Michel Fally, a principal with Deloitte Consulting LLP’s retail operations practice, for his timely feedback and suggestions.

The Three Rules

Contents

Introduction | 2

Intentional choices outperform ad hoc decisions | 4

A call to action | 11

Endnotes | 13

Shopping for success: The three rules in retail

Introduction

THE retail industry has faced more disrup-tive changes in consumer behavior

over the last decade than in the last century. The face of retail has shifted dramatically in the past 25 years from brick-and-mortar stores and catalogs to omnichannel. The era of the con-nected consumer, spurred by technol-ogy innovation, has forced retailers to fundamentally rethink almost every aspect of their operations. Mobile devices are making it easier for custom-ers to find what they are looking for, check competitor pricing on the go, and learn from the buying experiences of friends and fam-ily via social media. Omnichannel retail is here; how should retailers respond?

Many retail execu-tives are asking, “How do we compete in this changed world where the connected consumer is king?” Changing market conditions and new entrants have resulted in retailers being faced with numer-ous strategic alternatives. The ability to create a truly differentiated position in a crowded marketplace may require bold action and difficult decisions on trade-offs between

quality and cost, location and convenience, and service and price. Given the myriad of options, how should management choose? How do leaders make the right decision? What principles should guide their decision making?

In a recently published book, The Three Rules: How Exceptional Companies Think, Michael Raynor and Mumtaz

Ahmed provide guid-ing principles (“three rules”), based on exten-sive empirical research, that companies can adopt to differentiate themselves and sustain long-term performance (for details, see the side-bar “About The Three Rules”). To explore this concept, we have selected three current trends that are top of mind for many retail executives—omnichan-nel presence, global-ization, and customer engagement—and

discussed how the rules apply in each case. Our objective is to create a lens through which retailers can consider their choices relative to their peers. In the next few sections, we will discuss how retailers are approaching these trends and adapting the three rules to drive revenue and achieve exceptional performance.

The face of retail has shifted dramatically in the past 25 years from brick-and-mortar stores and catalogs to omnichannel.

The Three Rules

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ABOUT THE THREE RULES More than five years ago, Deloitte launched the Exceptional Company research project to determine what enabled companies to deliver exceptional performance over the long term. Adopting a uniquely rigorous combination of statistical and case-based research, this project has led to over a dozen publications in academic and management journals, including the Strategic Management Journal, Harvard Business Review, and Deloitte Review.1 The fullest expression of this work to date is in The Three Rules: How Exceptional Companies Think (www.thethreerules.com).2

The project studied the full population of all publicly traded companies based in the United States at any time between 1966 and 2010, encompassing more than 25,000 individual companies and more than 300,000 company-years of data. Performance was measured using return on assets (ROA) in order to isolate the impact of managerial choices: Measures such as shareholder returns often confound company-level behaviors with changes in investor expectations.

Using a simulation model, the researchers estimated how well each company “should” have done given its industry, size, life span, and a variety of other characteristics. They then compared this theoretical performance with how well each company actually did. A company qualified as “exceptional” if it surpassed its expected performance by more than population-level variability would predict.

Not all exceptional companies are equally exceptional, however. The researchers identified “Miracle Workers,” or the best of the best, and “Long Runners,” companies that did slightly less well but still better than anyone had a right to expect. In the entire database, there were 174 Miracle Workers and 170 Long Runners.

To uncover what enabled these companies to turn in this standout performance over their lifetimes, the researchers compared the behaviors of Miracle Workers and Long Runners with each other and with “Average Joes,” companies with average lifespan, performance level, and performance volatility.

First, to understand the financial structure of exceptional companies’ performance advantages, the researchers pulled apart their income statements and balance sheets. This provided invaluable clues: Miracle Workers systematically rely on gross margin advantages, and very often tolerate cost and asset turnover disadvantages. In contrast, Long Runners tended to rely on cost advantages and lean on gross margin to a far lesser extent.

Then, detailed case study comparisons of trios—a Miracle Worker, Long Runner, and Average Joe—in nine different sectors revealed the causal mechanisms behind these financial results. Specifically, exceptional performance hinged on superior non-price differentiation and higher revenue, typically driven by higher prices. Nothing else seemed to systematically matter; in fact, exceptional companies seemed willing to change anything, and sometimes just about everything, about their businesses in order to sustain their differentiation and revenue leads.

Hence, the three rules:

1) Better before cheaper: Don’t compete on price, compete on value.

2) Revenue before cost: Drive profitability with higher volume and price, not lower cost.

3) There are no other rules: Do whatever you have to in order to remain aligned with the first two rules.


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Intentional choices outperform ad hoc decisions

WHILE the rules seem intuitive to most, the majority of US companies—retail-

ers in particular—do not follow them, and thus earn average returns in the market. Retailers today compete across multiple dimensions, including brand, price, selection, location, and experience, and spread their investment dol-lars across these areas. Our research discov-ered that consistent superior performers are intentional in determining the basis on which they choose to compete and in developing operating strategies to support their desired position. Their investments are focused and their conviction in defending their uniqueness is unwavering.

Given a certain strategic opportunity when there are different paths or alternatives that are defensible . . . company leaders could reason-ably choose to go left or right. But in the face of ambiguity, they should choose the path consistent with the rules.

Company leaders could reasonably choose to go left or right. But in the face of ambiguity, they should choose the path consistent with the rules.

The Three Rules

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How executives approach the “free shipping” choice will differ based on whether a compa-ny’s competitive positioning is driven by price or service, as well as by leaders’ adherence to the three rules.

For retailers that compete on price, col-lecting fees for shipping makes perfect sense; provide the lowest online price and allow the consumer to select from a myriad of options

and prices for receiving the products. Yet the three rules tell us that retailers that com-pete on price rarely achieve sustained superior profitability.

For retailers who compete on service and experi-ence, the decision is much more difficult. How does the first rule—“better before cheaper”—apply? What constitutes “better?” Is it enough

to offer free three- to five-day shipping and charge for expedited shipping? How does the consumer view the various options? Can the company hold the line on pricing to extract a significant enough “premium” to cover the

Omnichannel and the promise of free shipping

The competitive dynamics intro-duced by omnichannel retailing—an approach that seeks to provide con-sumers with a seamless experience across all channels—requires retailers to fundamentally shift their operating model. The market is rapidly evolving from separate sales channels and experi-ences to a more consistent interaction with the customer regardless of channel. Shopping has gone from an experience constrained by time and space to an experience that can take place anytime and anywhere. There are seemingly endless tactical operating decisions that need to be made to compete effectively in this environment. But in the absence of a strategic lens through which to evaluate these choices, a retailer could easily make tacti-cal decisions that run counter to its desired competitive position.

For example, one frequent operating ques-tion is: Should we offer free shipping for prod-ucts purchased online or in-store and fulfilled from another location? The cost of shipping for online or mobile purchases is significant for most retailers, and many struggle with whether

to charge or ship “for free.” On the one hand, collecting fees for shipping can become a small profit center within the supply chain; on the other, collecting fees could be inconsistent with a retailer’s brand promise to the consumer.

Shopping has gone from an experience constrained by time and space to an experience that can take place anytime and anywhere.


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added cost of shipping? These are all questions that need to be answered through the “bet-ter before cheaper” lens. A seemingly simple economic decision becomes suddenly much more complex.

But recall rule three: “There are no other rules.” There are multiple ways to remain true to “better before cheaper” and “revenue before cost,” and the specific choice a company makes will depend on its competitive environment, brand promise, customer characteristics, and other factors. To illustrate, consider how Home Depot and Coach, both Miracle Workers with a brand promise of service, have answered the question of shipping costs. Home Depot provides free standard shipping to home on most orders over $45, and Coach provides free

standard shipping to home on all continental orders over $150.3 Each has responded differently depending on its individual circumstances, and each may vary the policy based on time of year, but each hewed to the rules. There is no recipe or sure-fire process for getting the right answer, but the three rules have kept them focused on the right path.

Going global with a unique value proposition

Expanding into new territories and untapped markets is an alluring prospect for growth. However, global expansion is a

complex undertaking. It requires substantial planning and investment to develop a sound strategy. Many retailers have had to slow expansion because they did not fully appreci-ate the complexities of the political, economic, regulatory, and customer landscape or the local market’s operational and governance require-ments. For many US retailers, even the most obvious choice of expansion—into Canada—is not as easy as may be expected. Until recently, the Canadian market was difficult to expand into due to a weak Canadian dollar, higher costs, and limited real estate development.

The three rules can be instructive in helping to reduce pitfalls. Retailers use a number of strategies to expand into new markets, includ-ing strategic partnerships, acquisitions, and/

or wholly owned expansion. Before developing their global strategy, retailers should understand their unique value propo-sition in the context of the rules. A key question to address is: How does the company differenti-ate itself today, and how should it posi-tion its brand in the

global market in the future? Many retailers assume that their

brand will translate favorably into international markets without fully

appreciating their own competitive position or the dynamics of the local market. In emerging markets like Mexico and Brazil, established retailers compete heavily on price. Because goods are already inexpensive, it is extremely difficult to improve margins with a strategy built on lower prices. This makes it even more important for retailers expanding into these emerging markets to focus on “better before cheaper” and “revenue before cost.” Based on the research in The Three Rules, we have learned that price-based competition rarely

Many retailers assume that their brand will translate favorably into international markets without fully appreciating their own competitive position or the dynamics of the local market.

The Three Rules

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delivers exceptional results in the long run. Retailers may have to reduce prices to adjust to local market economics when expanding globally, but a differentiated strategy guided by “better before cheaper” will create a brand that attracts and sustains customers going forward.

Even within a price-conscious market, there are multiple avenues for non-price differentia-tion. For example, Brazil’s largest appliance and home electronics retailer, Magazine Luiza, offers credit to its customers and uses its extensive customer credit database to create loyalty programs that recognize high-volume customers. In a country where almost half the population does not have a checking account, Magazine Luiza provides various financial services, including personal loans, insurance policies, installments, and affordable credits. About 80 percent of Magazine Luiza’s sales are on credit.4 Magazine Luiza’s flexible approach to reaching Brazil’s middle- and lower-income demographics with a variety of formats and payment options has positioned it well to avail itself of the recent consumer boom the country has undergone. Magazine Luiza has differentiated itself by making profit a function

of factors other than price, such as how much credit was extended to customers and at what interest rates.

Magazine Luiza also uses the “revenue before cost” rule. One of the innovative strate-gies it has adopted is to set up virtual stores, which account for 52 out of the company’s 350 stores. The virtual model is based on four major pillars: no on-site products, attentive on-site service, strong technological sup-port, and integration with the community. A number of other companies have failed at implementing virtual store concepts because they adopted a self-service model to cut costs. Magazine Luiza, however, has invested in its customer service to educate and guide custom-ers and to provide them with personalized service. The company is often ranked as one of the “best places to work” in Brazil.5 In addi-tion, the company’s marketing tactics include providing one hour of free Internet access to virtual store shoppers, with another hour free if a customer brings a friend. Magazine Luiza also sets aside space in its virtual stores for customer education, local charity partner-ships, and customer information sessions.6 In


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short, instead of focusing on cutting costs, the company has invested in a number of ways to generate revenue.

When planning international expansion, retail companies can consider reinvesting cost savings from developed markets to pursue growth in emerging markets—a good practice that aligns with the three rules. For example, one company is pursuing productivity savings in Europe and North America to fund invest-ments in emerging markets. The company pays for investments in emerging markets by expanding gross margins and aggressively managing costs in North America and Europe, with a continued focus on delivering gross productivity of more than 4 percent of cost of goods sold and driving overhead savings. The majority of its margin savings in North America will come from reinvent-ing the supply chain network, introduc-ing new production lines that incorporate leading-edge technol-ogies, and repatriat-ing production from co-manufacturers. In Europe, the company is already competi-tive with peers, but it is targeting an improve-ment of 250 basis points in operating income margin. The company intends to reach this target by streamlining its supply chain and by continuing to reduce overhead. Steps toward the latter include the integration of Central European countries into the company’s central-ized category-led model and the use of service centers in low-cost locations. The company anticipates these actions will expand base oper-ating income margin over the next three years and plans to reinvest a portion of these savings

to fund growth in emerging markets and to fund ongoing restructuring.

Once a retailer has cleared the hurdles of selecting a market and developing a differ-entiated strategy, the method of entry can be significantly influenced by the three rules. For example, if a retailer has determined that its competitive advantage lies in the brand experi-ence and customer service, a franchise model may be inappropriate. In a franchise arrange-ment, a retailer may cede too much control over operating decisions such as assortment planning and staffing levels to the franchisee,

adversely impacting the customer experi-ence. A strategy of “owned stores” in a particular market, while perhaps gener-ating slower growth and requiring greater initial capital invest-ment, could provide the level of control necessary to ensure a “better before cheaper” customer experience globally.

To underscore how the three rules can apply during global expansion, even among retailers whose brand is built explicitly on offering low prices, consider

Costco’s entry into Taiwan.7 Costco opened its first store in Taiwan in 1997. Its Taiwanese business became profit-

able about five years after its initial investment, and has been profitable ever since. Although the Costcos in Taiwan, like their US coun-terparts, try to guarantee that their prices are the market’s lowest, they use many tech-niques to also apply “better before cheaper.” Examples include:

Once a retailer has cleared the hurdles of selecting a market and developing a differentiated strategy, the method of entry can be significantly influenced by the three rules.

The Three Rules

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• Balancing the foreign with the familiar: The stores strive to offer an “American experience” while cultivating local tastes, making the Taipei store the chain’s second most profitable.

• Leveraging US-origin goods: About 40 percent of the chain’s merchandise is from the United States, making it stand out from local and foreign rivals. The Taipei store’s top bakery item is bagels, which use dough imported from New York. The store sells 54,000 units a week.

• Adapting to local tastes: Costco’s Kirkland brand beef steak, which is a US store product, is thinly sliced to satisfy local preferences for hot-pot meat, for instance. Fish are sold whole instead of filleted. And in the food court, alongside American soda and pizza are such local varia-tions as Peking duck pizza.

• Implementing leading practices: Costco has trained local suppliers to use Costco-style pallets and forklifts to save on labor, an example of both cutting costs and increas-ing revenue via increased volume.

• Improving service: Costco introduced the concept of a generous return policy in a culture where returning merchandise is uncommon. For instance, Costco allowed locals to return half a watermelon because it

was not sweet enough. The company made the return experience so pleasurable that it become an advertising item.

There is no sure strategy for a successful global expansion. However, retailers seeking to penetrate new markets will be faced with numerous decision points where they will have to pick among many, seemingly equally reasonable options. Based on our research, the option that is most aligned with the three rules is most likely to result in long-term success.

Honing “better” to engage customers

Given the various avenues available today to drive customer loyalty, retailers are constantly chal-lenged by how best to engage the consumer. The abil-ity to anticipate the customer’s needs and to provide quality products and services yields repeat customers. However, identi-fying a customer engagement strat-egy that effectively

aligns with evolving consumer behavior can be a difficult task. If retailers are to follow the three rules, they must understand how to define “better” for themselves.

Retailers must ask themselves: What are the elements of the brand, experience, or connec-tion with the customer that cannot be sacri-ficed? Without a specific focus, the connection with the customer will be hollow and not yield the desired result. This area may be the tricki-est in which to apply the three rules, but the costs of failing to do so are high, as the case of Filene’s Basement illustrates. The company,


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subsequently purchased by Syms Corporation, was a legendary “off price” department store known for its deals on high-end merchan-dise.8 However, it filed for bankruptcy in 2011 due to its inability to develop non-price differentiation amid a shifting marketplace. With increased competition from department stores, its original differentiator in the market-place—price—was no longer a factor, giving its rivals equal footing. Filene’s inability to define “better” to generate customer loyalty was ulti-mately its undoing.

Any good customer engagement strategy begins with segmentation. Decisions on target segments help inform choices about how and where to invest in developing a relationship with the customer. If a customer engage-ment strategy targets the Millennial genera-tion, for example, then the way the company engages these consumers will be tailored to their particular characteristics. We know that Millennials comprise more than 20 percent of the current population, that they grew up using technology, and that they are early adopters of new innovations. They are accustomed to having their life on display through various avenues and they are known to value diversity and change. Many want their lives to have meaning; therefore, community involvement and self-expression are important to them.

Given this context, retailers targeting this market may experience success by investing in social causes that embody the brand’s essence, as well as investing in tools to support and

streamline customer engagement. Millenial consumers may be more willing to pay for a brand if they understand how it connects to their value system. Consider TOMS, the popular footwear retailer. TOMS has invited its customers to actively participate in its philan-thropy by purchasing their products. Through its One for One program, TOMS has commit-ted to help one person in need through various giving programs for every product purchased by a customer. TOMS has been able to effec-tively link its charitable activity to customer purchases. This is a simple way that TOMS has been able to tie a social cause to the brand and actively engage its customer base. By pur-chasing a product, the customer is essentially making a donation that collectively impacts children in over 50 different countries. TOMS’s engagement strategy is one of many equally valuable options that retailers can consider. The specific choice is less important than the type of choice made: the choice to strive to be uniquely better, not uniquely cheaper.

In applying the three rules to marketing investments, branding and social causes may be two areas of cost that should not be sacri-ficed for the sake of savings. When the goal is to achieve sustained exceptional performance, the need to connect with the customer to drive revenue could far outweigh the value of strate-gies to reduce cost. Other areas of marketing, such as advertising or special promotions, may be susceptible to change. Remember: “There are no other rules.”

The Three Rules

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RETAILERS need to know what they stand for in the long term to maintain a dif-

ferentiated position in the marketplace. Differentiation is especially difficult in retail, which is an industry of “fast followers”: When a competitor sees a successful strategy elsewhere, it will move quickly to replicate that suc-cess. Staying the course and constantly applying the three rules is difficult. It requires leadership to make hard decisions in the short term for long-term gain. The ability to stay true to a long-run strategy will lend itself to exceptional performance.

There are several steps that retailers can consider in applying the three rules.

Step 1: Develop a clear picture of the competitive strategy

Retailers must honestly evaluate their value proposition in the market to effectively capital-ize on it. Consider the premium that has been placed on product, service, or location, and make sure that strategic decisions support that position. According to the three rules, differen-tiation and pricing power are the most impor-tant goals in relation to the overall strategy.

Step 2: Be willing to make trade-offs

Any ongoing initiative or project that may conflict with the basic strategy should be re-evaluated. Existing projects may need to be abandoned in order to align resources appropriately. If the strategy involves launching a social media platform, then ongoing invest-ments in a direct mail campaign may not be appropriate, for example. Remember that an undifferentiated strategy is not a strategy likely to yield superior results.

A call to action

Step 3: Engage the entire organization

The ability to on-board resources and successfully integrate diversity of thought under one strategy can help drive a suc-cessful outcome. As an organization, take the time to define which operating principles are non-negotiable, and instill those into each associate. Successful retail campaigns adopt consistency across all organizational plat-forms; the same message is communicated regardless of which channels or personnel are delivering it.

Step 4: Continually measure successIn order to measure progress, organizations

must know how well they are performing. Selecting the right metrics to monitor is a criti-cal first step. While The Three Rules research used return on assets to measure relative performance—to take advantage of its com-bination of profitability and asset utilization


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measures—there are many others that can be employed. Committing to a consistent set of measurements will provide a compass for navi-gating the competitive waters and determining the degree of success. For retailers, evaluating additional profitability ratios such as compa-rable store sales, gross margin, and operating margin is equally valuable.

While every company is different, the three rules provide substantive—yet flexible—guid-ing principles that managers can put into action. Each company can chart its own course to market differentiation. Each can find its

Deloitte’s Retail & Wholesale Distribution practice helps retailers and wholesalers address issues across areas including customer, channel, and market strategy; merchandising; supply chain; ERP and enterprise transformation; M&A; and talent management. We serve companies operating in general/mass merchandise, food and drug, apparel and specialty, and Internet retail, as well as diversified and specialty wholesale. Contact the authors for more information or learn more about our Retail & Wholesale Distribution practice on www.deloitte.com.

secret ingredient to propel it to new heights of performance.

The question is simple: How should you apply the three rules to your own strategy to differentiate yourself? How do you define “better” or increase your focus on revenue over cost? For retailers, the ability to antici-pate and meet customer needs is the highest priority. The path to extended success, maybe even miracles, is to pursue opportunities that leverage the concepts of differentiation and pricing power without sacrificing the organiza-tion’s mission.

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Endnotes

1. See Deloitte University Press, “The Exceptional Company,” http://dupress.com/collection/the-exceptional-company/, for more.

2. Michael E. Raynor and Mumtaz Ahmed, The Three Rules: How Exceptional Companies Think (New York: Penguin Books, 2013).

3. Home Depot, http://www.homedepot.com/c/Featured_At_Home_Depot#ShipHome, accessed April 8, 2014; Coach, http://www.coach.com, accessed April 8, 2014.

4. Planet Retail, Retailer profile: Magazine Luiza in Brazil, February 2014.

5. Barclays Equity Research, Maga-zine Luiza, August 14, 2012.

6. Leticia Costa and Fernando Fernandes, Success-ful retail innovation in emerging markets: Latin American companies translate smart ideas into

profitable businesses, Booz & Company, 2006, http://www.booz.com/media/uploads/Success-fulRetailInnovationinEmergingMarkets.pdf.

7. Andria Cheng, “Costco cracks Taiwan market: US wholesale club builds sales by tailoring big box retailing to local tastes,” Wall Street Journal, April 1, 2010, http://online.wsj.com/news/articles/SB10001424052702303395904575157910930303400.

8. David Goldman, “Syms and Filene’s Base-ment to close all stores,” CNNMoney, November 2, 2011, http://money.cnn.com/2011/11/02/news/companies/syms_filenes_basement_closing/index.htm.

9. TOMS, “Our movement,” http://www.toms.com/our-movement/l#stepbystep, accessed March 13, 2014.

Rodney R. SidesPrincipalDeloitte Consulting LLP+1 704 887 [email protected]

Vikram A. RaoSenior managerDeloitte LLP+1 617 437 [email protected]

ContactsTonya A. WilbornSenior managerDeloitte LLP+1 214 840 [email protected]

Whitney YoungSenior sector specialistDeloitte LLP+1 617 437 [email protected]


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Three Rules Retails

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